Cost Estimating Principles

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1988 Robert I. Carr 1

COST ESTIMATING PRINCIPLES

By Robert I. Carr,1

Fellow, ASCE

ABSTRACT: Estimates of materials, time, and costs provide information to some

construction decisions in a similar way that financial accounting information providesto others. Financial statements are required to comply with generally acceptedaccounting principles, described in accounting literature to ensure information is

accurate and useful to decisions. This paper suggests general estimating principles thatsimilarly guide good estimating practice. An estimate must be an accurate reflection of

reality. An estimate should show only the level of detail that is relevant to decisions.Completeness requires that it include all items yet add nothing extra. Documentation

must be in a form that can be understood, checked, verified, and corrected. Attentionmust be given to the distinction between direct and indirect costs and between variable

and fixed costs. Contingency covers possible or unforeseen occurrences. Both theexpected value of possible identified events and the expectation that events will occur

that cannot be identified in advance.

INTRODUCTION

To estimate is to produce a statement of the approximate quantity of material, time, or cost to

perform construction. This statement of quantity is called an estimate, and its purpose is toprovide information to construction decisions. Typical decisions include procurement and

pricing of construction, establishing contractual amounts for payment and controlling actualquantities by project management.

Estimates provide a similar level of information to some decisions as financial accountinginformation provides to others. Financial statements are required to comply with generally

accepted accounting principles (GAAP), described in accounting literature, to ensure that theinformation they provide is accurate and useful to decisions. Estimating literature does not

provide similar generally accepted estimating principles against which estimating practices canbe judged. This paper suggests general estimating principles that guide good estimating practice.

GENERALLY ACCEPTED ACCOUNTING PRINCIPLES

Cost estimating shares some similarities with financial accounting. Both provide financialinformation that is needed in important decisions by a firms management, as well as financial

information to decisions outside the firm. Both also require standard practices that can berepeated from project to project or period to period. Selecting estimating and accounting methods

is as much an art as a science, to meet practical situations of reality.

Financial accounting practice must conform to generally accepted accounting principles,

which is generic for a large group of standards, conventions, concepts, guidelines, andassumptions that guide but do not dictate accountants decisions. Financial data can be

represented in a variety of ways and still comply with GAAP. There is no one general set of

1 Professor, Department of Civil and Environmental Engineering, University of Michigan, Ann Arbor, MI 48109-

2125, (734) 764-9420, Fax: 764-4292, Email: [email protected].


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GAAP, as demonstrated by the fact that different accounting textbooks have different lists of

GAAP items. However, the different lists and descriptions do not conflict, in that they describethe same basic approach to financial accounting.

Estimating does not have a similar literature on generally accepted estimating principles(GAEP), though there is considerable literature on estimating practice. Estimating literatures

primary focus is on estimating formats, procedures, and processes for particular applications. Itgives little attention to establishing a fundamental base or foundation to estimating decisions, so

that the formats, procedures, and processes will provide estimates that are accurate and useful fordecisions. This leaves a particular void in teaching estimating, whether in academia or in

practice. Engineers in estimating need to understand its fundamentals in the same manner thatengineers in design need to understand design fundamentals.

GAAP used in accounting does not fill this void. Though accounting and estimating havestrong similarities, they are basically different. Accounting is fundamentally historical,

describing financial position and activity over the past, depending primarily upon objectiveevidence. There is some application of GAAP to estimating; however, some accounting

principles have no application to construction estimating and others conflict directly with goodestimating practice.

I have attempted to fill this void by describing general principles that I believe are generallyapplicable to estimating construction costs. The basic criteria under which I created the list is that

of accuracy and usefulness for the normal range of business decisions for which estimates areused. These include conceptual and preliminary cost estimates during design, estimates of direct

construction costs as a basis for competitive bidding, estimates of cost to complete a project as abasis for percentage of completion accounting for project gross income, estimates to establish

budgets against which to control construction costs, and estimates of cost as a basis for analyzingcontract changes.

GENERALESTIMATINGPRINCIPLES

Reality

Anyone can come up with a set of numbers. A challenge to the estimator is to produce anestimate that is an accurate reflection of reality. This is first a question of professional experience

and judgment, and second a matter of relevant historical data. To estimate at a detailed level onemust mentally construct a project, selecting materials, methods, equipment, and crews to fit the

design. The estimator then uses the best information available to estimate the costs of performingthe required work using the selected resources. This information may be cost or crew time data

from past work. It may be calculations based on detailed analysis of the construction process. Itmay be the estimators best guess of cost and time. Usually it is a combination of these.

It is particularly important that the estimator not select information simply for its convenienceor its appearance of objectivity. All too often an estimator will use numbers that are handy or

from a source that would seem to release the estimator from personal responsibility. They maybe cost data from past projects or published in estimating guides. The use of such data without

knowledge of its similarity to the work at hand produces an inaccurate estimate, because it is notbased upon the realities of the current project.


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Level of Detail

Estimating takes time, which is expensive, and one should spend it only on detail that is

relevant to decisions. Relevancy is based on two criteria: (1) If a particular level of uncertainty isacceptable in making a decision, the level of detail that provides this level of uncertainty is

acceptable; and (2) the effect of the level of detail on accuracy of the estimate should be

reasonably uniform for all components of the estimate.

At the conceptual stage of design, the owner is trying to decide whether to continue withfacility procurement and the designer is working with the owner to establish the scope and

general characteristics of the facility. An order of magnitude estimate is sufficient for decisions,particularly if it is sensitive to changes in scope.

When design is completed, it is important that contract prices be based on adequate estimatingdetail. Yet even here one should avoid needless detail. Detailed estimates will include

procurement, fabrication, and installation of materials and equipment, but fasteners such as nailsand screws and lengths of welds are not individually counted.

Completeness

Another challenge is to include all items that will be in the facility yet to add nothing extra.The estimator must have the vision to see beyond the obvious components and their primary

costs of construction, primarily in preparing cost estimates prior to completion of design. Inestimating industrial work, the major items of process equipment are obvious early in the design

period. Estimates must include not only costs of procuring equipment but also the cost of itsinstallation and the cost of piping, wiring, controls, and structure to support it. In addition to the

cost of performing construction, there are major costs of providing administrative and physicalinfrastructure for the construction process, such as permits, insurance, financing, security,

transportation, accounting, purchasing, utilities, warehousing, and shops. Onto this can be added

costs of delays and changes that will have occurred before the project has been completed.There may seem to be a conflict between the principles of completeness and level of detail,

but there is none. By level of detail, an engineer describes detail only at the level appropriate to

decisions; but by completeness, the engineer ensures that all costs are included. Therefore, theproper level of detail for a conceptual estimate may be a list of only the major items of

equipment. Yet, at that level of detail, the cost of each item must include all construction costs.Similarly, level of detail precludes individual counting of builders hardware or small tool items.

However, their cost must still be included in the estimate in order that it be complete.

Documentation

An estimate is a permanent document that serves as a basis for business decisions. It must be

in a form that can be understood, checked, verified, and corrected. This requires that the sourceof each number be readily apparent not only to the person who prepares the estimate but also to

others who follow. Conditions that were assumed must be identified. Methods of construction.equipment spreads, and crews that were selected in the estimating process must be stated, if they

are not obvious. The estimate should be organized to be followed easily. It should be in a formthat can be easily duplicated by photocopy or computer, and it should be subject to the same

level of document control as other permanent documents, such as contracts, proposals, and


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purchase orders. One should not be embarrassed to have it appear as evidence in settling

disputes.

On the other hand, an estimate is a working document. It is a private document, meant only

for the parties who are using it for decisions. It may be prepared in a hurry to meet a deadline.with adjustments up to the last minute based on information that is not available earlier. It is

usually not meant to be a finished financial statement nor meant for formal presentation. A well-engineered estimate is expected to include side notes, erasures, crossed-out items, and jotted-in

corrections. This produces a well-documented, readable working document that can be easilyupdated to produce accurate realistic estimates of costs. This is strongly preferred to a rigid,

presentation format that is not suited to estimating processes.

Direct and Indirect Costs

A direct cost of an activity is physically traceable to the activity in an economic manner. A

direct cost is one not counted if the activity is not performed. Indirect costs are business costsother than direct costs of construction activities; they are not physically traceable and are counted

even if the activity is not performed. Indirect costs are also known as overhead.Construction costs are classified as materials, labor, and equipment. Direct materials for

concrete walls include ready-mix concrete delivered to the site and placed in the forms,reinforcing steel fabricated off site and tied and placed in the forms, and plywood and form ties

from which the forms are constructed. Direct labor includes carpenters who fabricate and erectthe forms; reinforcing ironworkers who place the steel; and laborers who place concrete, strip

forms, and patch the concrete surface. A concrete pump and elephant trunk brought onto the siteto place concrete is a direct equipment cost, and its operator is direct labor.

Indirect costs consist of: (1) Large costs that would have occurred even if an activity had notbeen performed; and (2) small costs that would be direct except that assigning them to activities

is not economical. The job-site superintendent and tower crane are examples of the former. Thesuperintendent supervises the concrete activity, and the crane (and operator) lift reinforcing steel

and form panels. Both are used for the concrete-wall activity; however, both are still needed evenif no walls are constructed or if the quantity of walls changes. Their costs cannot be traced

directly to the concrete-wall activity, and they are considered indirect costs of concrete walls anda part of project overhead. Nails to construct forms, wire to tie the reinforcing steel, and a

portable power saw are examples of small costs that are not economical to trace to concretewalls. Nails, tie wire, and small tools are therefore considered project overhead. They are

included in the estimate as a percentage of direct cost (percentage of lumber cost, for example)or as a cost per unit of output (cost per board foot of lumber or square foot of contact area) rather

than as an individually counted direct cost.

There are two levels of overheads or indirects. Project overhead is all costs that areeconomically traceable to a project but that would not have occurred had the project not beenperformed. The superintendents salary and the tower-crane rental are indirect costs of the

concrete process and other construction activities. However, if the project were not performed,there would be no supervision or crane rental costs. They are therefore project overhead costs,

which are direct costs of the project.

The second level of overhead consists of the costs of running the construction business that

are not economically traceable to its projects. These are called general overhead, general office


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overhead, or general and administrative (G and A) costs. The estimating department is necessary

in obtaining work, but only a few of the many projects estimated result in contracts. Its expensesare therefore not traceable to its projects, even those few it wins. General office and warehouse

rental, insurance, and maintenance are necessary but are not direct costs of projects. Thepurchasing and accounting departments serve the different projects of the company, but: (1) It is

not economical to trace their costs to the projects; and (2) obtaining a project does not directlyimpact purchasing and accounting department costs. All of these costs are included in general

office overhead.

The direct/indirect cost concept is hierarchical. The roofing subcontract amount is a direct

project cost to the prime contractor. The subcontract includes the roofing contractors estimateddirect and indirect costs and profit. Therefore, they are part of the prime contractors direct

project costs. Similarly, the prime contractors bid is the sum of: (1) Its estimated direct activitycosts; (2) its project overhead; and (3) its general office overhead and profit. These become part

of the owners direct project cost. The owner will have additional direct project cost forarchitect/engineer and its own direct expenses for supervision, furnishing, startup, etc. Thus one

partys indirect costs and markups become another partys direct cost. In fact, if the owner were

building a production plant, all the projects direct costs and indirect costs are transmitted tocustomers as their direct costs of purchasing products manufactured at the plant.

Variable and Fixed Costs

Costs can be classified by whether they change as the volume produced changes. Volume or

quantity of construction activity is measured in many ways, such as linear feet (linear meters),square feet (square meters), or cubic yards (cubic meters) produced, hours worked, units

installed, and months rented. If a cost changes in proportion to a change in volume or quantity, itis variable. If a cost remains unchanged in total despite wide fluctuations in volume or quantity,

it is fixed. Most activities are a mixture of variable and fixed costs. An example is a job-site shopto fabricate spools of pipe, which consists of four welding bays, two cutting bays, a storage area,

and an overhead crane. The cost of setting up the shop is a fixed cost of fabrication, because onceit is set up, its cost will not change if half as much or twice as much pipe is fabricated as was

expected. However, the hours of wages paid to pipefitters depends on the number of spoolsfabricated, as does the length of rental of welding machines, the fee of the weld inspector, and

quantity of pipe. These are all variable costs of pipe fabrication.

Most of general and administrative costs, such as main office rent, insurance, taxes, and

depreciation; salaries of main office personnel; and ownership costs of equipment; can beconsidered fixed for a given time period. They are often called period costs, because they occur

or expire with time. Though considered fixed over a given time period, they may change con-siderably from one period of time to another as the level of business changes or as equipment or

real estate is bought or sold. Many project overhead costs are fixed, particularly costs ofinstalling job-site services. Examples of fixed costs for a broad range of project quantities

produced are installation of electric and phone service to the job site and installation of shops,hoist, parking, and warehouse facilities. Project insurance and building permit are variable costs

because they vary directly with cost of construction. Project supervision, security, and rental forcrane and job-site offices are project period costs. They vary with length of project and are

therefore considered variable costs.


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The difference between variable and fixed costs is particularly important in determining

relevant costs for changes in contract quantities. The two common types of competition are lumpsum bids that give the owner fixed prices and unit price bids that give the owner sets of variable

costs. However, neither accurately represents a contractors costs, which are a mixture ofvariable and fixed costs. Each type of contract allows adjustment for the differences between the

contract representation and the real cost picture. Though the lump sum contract contains novariable costs, its general conditions allow an owner to adjust quantities by change orders and

make provision for changes in contract sum to recognize changes in quantities. Unit pricecontracts are designed to be more easily adjusted. But because the unit prices represent a mixture

of fixed and variable costs, a change in quantity affects contract amount by more than thevariable cost. Large quantity changes can cause major inequities for contractor or owner, and

unit price contracts usually contain clauses allowing renegotiation of unit prices if there aremajor changes in quantities.

Contingency

An estimate is a predictionan approximationthat provides information for decisions and

is a surrogate or substitute for actual measurement that is not economical or possible. It isconsidered accurate if it is sufficiently close to actual performance that decisions based on theestimate are the same as decisions based on actual performance, were actual performance

available.

Though the guiding concept of an estimator is accuracy, by its nature an estimate is uncertain.

An estimator must live with uncertainty, though it is not his friend. In fact an estimator must notonly live with uncertainty, but he must estimate and control uncertainty, because the uncertainty

contained in an estimate is as important information as the estimated value itself.

A contingency is a possible or unforeseen occurrence. In estimating, the word contingencyis

used for two types of estimates. The first is the expected value of a possible identified event. For

example, if there is a 20% chance a contractor may require two dozers instead of one, it mayinclude a cost of 20% (or more) of the cost of the second dozer as a contingency. The secondtype of contingency is the possible cost of unforeseen events: events that cannot be identified

because the engineer does not know what can happen. This second type is a true contingency andthe one that needs close attention, because it is a margin for error.

The most worrisome thing in engineering (and probably in every profession) is the occurrenceof the unanticipated. The possibility of unanticipated events flies in the face of the knowledge

that is the cornerstone of professional practice and control. The unanticipated may be of such amagnitude and consequence that it overwhelms ones carefully considered decisions and actions,

and it controls the outcome. The worst of it, however, is not to know when one does not know,not to know when to expect error, and not to provide for the occurrence of expected error.

An estimator is strongly interested in accuracy, which demands knowledge of what will occur.Contingency represents an unknown, which seems to conflict with accurate estimating. However,

when an estimator expects events to occur that cannot be identified in advance, accuracydemands they be represented in a cost estimate. An example is a project that is being planned in

an area in which the estimators have little experience. They know from past projects in areas inwhich they had little knowledge that construction difficulties occurred that they could not

identify in advance. And these unidentified events added an average of 20% to the cost of events


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and activities that they had identified. They therefore add 20% to their estimated costs, because

not to do so would not accurately reflect their best estimate of final cost.

CONCLUSION

These estimating principles may be considered generally acceptable cost estimating principles

to the extent that most engineers would generally accept them as a base for good estimatingpractice. Others are welcome to state their own view of acceptable principles and practices,

because it is through such discourse that general principles and good practice are defined andbecome accepted by the profession.

Cost Estimating Principles

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